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Islamic Finance: What it means for Microloans to be Sharia-Compliant

Posted by on Oct 8, 2014

The difference between Islamic finance and “regular” finance is this: generally, in Islamic finance, risk and profit are shared between lenders and borrowers thereby tying the success of lenders to borrowers. It has grown steadily since the emergence of large Islamic banks in Saudi Arabia in the 1970’s and opens a new avenue for current cash-only populations (Garrett 2011). This is particularly true for the poor and less educated who face many obstacles to benefiting from modern institutions, including a reluctance to participate in culturally and religiously condemned financial practices.
Mohamed (pictured above) has received two Islamic-compliant loans through the National Microfinance Bank (NMB) in Jordan, which offers both Islamic and regular financing options. “I know that in the end the price is the same, but the Islamic loan is better,” he told me. “The bank makes sure the loan is used for the right purpose. The money doesn’t just disappear”. The National Micro Finance Bank offers Murabaha loans meaning they purchase goods and then sell those goods to the borrower at a higher price which is paid in installments (Mahariq 2014). NMB’s borrowers, like Mohamed, never actually receive cash from the bank.
Concern over loan use is echoed by bank employees. “When you give a regular loan to someone, you never know if he is going to use it the way he said he would. Maybe he will use it for something else,” commented one former NMB loan officer. Islamic financing provides an extra layer of oversight which helps protect borrowers who might be uneducated and have little experience in financial planning. Islamic financing also provides added comfort to the borrower, knowing that the loan he/ she receives is permitted within his/ her faith (or “Halal,” as Mohamed put it.)
While cash flows between regular financing and Islamic financing may be very similar, investors cannot guarantee a return on their capital or even principal repayment because if an investment or a loan is unsuccessful, the burden should be shared by borrowers and investors instead of being born by borrowers alone (Musharakah on Shari'ah Ruling). At the same time, Islamic financing reduces the risk to financial institutions by giving them more power over how financing is utilized.
The ethical obligations of Islamic financing make it particularly compatible with the goals of microfinance institutions. When it comes to increasing the reach of microfinance institutions, Islamic finance seems to be a natural ally.